To understand the advantages of diversification, imagine you’re at the doctor’s office. As with most visits to the doctor’s office, the news isn’t good. The doctor explains that if you don’t start eating a balanced diet, you only have a few years left to live. Briefly, the doctor tells you that the rule of thumb for a balanced diet is to eat 50% carbohydrates, 30% fat, and 20% protein.
With pamphlets in hand explaining your new diet, you walk out ready to take action.
The first thing you do is look at the back of nutrition labels of the food you typically eat. With a calculator, you find that by eating oatmeal for breakfast, salad for lunch, and fish, brown rice, and vegetables for dinner, you’ll be perfectly within the 50:30:20 ratios. Actually, you like the simplicity of the three meals so much, you decide to eat that every day.
A few days go by, and you’re sticking to your diet. Unfortunately, you’re tired of eating the same three meals. Plus, you’re lacking energy on this new diet. Confused, you go back to the doctor.
On the second visit, , you learn to not only stick to the 50:30:20 ratios, but to consume a variety of each source. Specifically, you can’t rely on just a few sources of protein, like fish, you need a variety because different sources of protein offer different health benefits.
The Advantages of Diversification | Investing
When the doctor prescribed a diet of 50:30:20, think of that as your asset allocation between stock, bonds, and cash. When the doctor then said, you need to eat a variety of sources of carbohydrates, fat, and protein, that’s diversification.
Say you’re told that when you’re 25; a balanced portfolio consists of 85% stocks and 15% bonds. Knowing this, you put 85% of your portfolio into the stock market by buying just Apple Stock. Then, for the bond allocation, you invest it all in a Microsoft bond.
Technically, this portfolio is correctly allocated between stocks and bonds. However, just as your diet lacked diversification when you decided to eat the same food everyday, so does this portfolio–it needs a variety of different stocks and bonds.
The big questions is then, how many stocks and bonds does a portfolio need to have proper diversification? To answer that, let’s look at a quote from Warren Buffett.
“I believe in extreme diversification. I believe that 98 or 99 percent, maybe more than 99 percent, of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs. All they’re going to do is own a part of America. They’ve made a decision that owning a part of America is worthwhile. I don’t quarrel with that at all, that is the way they should approach it.”
This is exactly how I believe most members of Generation Y should invest, by indexing. Instead of just owning one stock and one bond, own them all.
And that is the advantage of diversification.
Photo by: Dominique Godbout